Swaps, also known as rollover rates or overnight financing rates, are the interest rate differentials used to calculate the cost or profit of holding a currency position overnight in the forex market. Swaps are typically calculated and applied at 5:00 PM New York time (known as the "rollover time") on trading days. Here's how swaps are calculated:
1. Interest Rate Differential: Swaps are based on the interest rate differential between the two currencies being traded. Each currency pair has its own interest rate associated with it.
2. Long and Short Positions:
- Long Position (Buy): If you are holding a long (buy) position in a currency pair, you are effectively borrowing the base currency (the one you are buying) and lending the quote currency (the one you are selling).
- Short Position (Sell): If you are holding a short (sell) position in a currency pair, you are effectively borrowing the quote currency (the one you are selling) and lending the base currency (the one you are buying).
3. Interest Rate Differential Adjustment: The interest rate differential is adjusted to account for any market factors that might affect the swap rate. These factors can include central bank interest rate decisions, market liquidity, and other economic conditions.
4. Direction of Trade:
If the interest rate of the currency you are buying is higher than the interest rate of the currency you are selling (in a long position), you will typically receive a credit to your account.
If the interest rate of the currency you are buying is lower than the interest rate of the currency you are selling (in a long position), you may incur a debit from your account.
5. Calculation of Swap Points: Swap points are calculated based on the interest rate differential and are typically expressed in pips. The formula for calculating swap points is as follows:
- Interest Rate Differential: The difference between the interest rates of the two currencies in the pair.
- Contract Size: The size of your position in the currency pair.
- Days in a Year: Typically, 360 or 365, depending on the broker.
6. Accounting for the Day: The swap points are usually credited or debited at rollover time, and the amount is adjusted based on the number of days you hold the position. For example, if you hold a position for one day, you'll be credited or debited the daily swap rate. If you hold the position over a weekend, the swap may be adjusted for the additional days.
It's important to note that swap rates can be both positive (credit) or negative (debit) depending on the direction of your trade and the interest rate differential. Traders should be aware of the swap rates associated with their positions, as they can affect the overall profitability of their trades, especially when holding positions for an extended period.